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On the Dynamic Panel Data Estimators

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Introduction An Empirical Exercise Illustration of System GMM

Dynamic Panel Data Analysis

Dr. Abdul Rashid

International Institute of Islamic Economics (IIIE)

International Islamic University, Islamabad

January 19, 2018

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Dynamic Panel Data Estimators

In the context of panel data, we usually must deal with unobserved

heterogeneity by applying the within (demeaning) transformation, as
in one-way fixed effects models, or by taking first differences if the
second dimension of the panel is a proper time series.

The ability of first differencing to remove unobserved heterogeneity

also underlies the family of estimators that have been developed for
dynamic panel data (DPD) models. These models contain one or
more lagged dependent variables, allowing for the modeling of a
partial adjustment mechanism.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Nickell Bias

A serious difficulty arises with the one-way fixed effects model in the
context of a dynamic panel data (DPD) model particularly in the
“small T, large N” context. As Nickell (Econometrica, 1981) shows,
this arises because the demeaning process which subtracts the
individual’s mean value of y and each X from the respective variable
creates a correlation between regressor and error.

The mean of the lagged dependent variable contains observations 0

through (T − 1) on y, and the mean error—which is being
conceptually subtracted from each it —contains contemporaneous
values of  for t = 1 . . . T. The resulting correlation creates a bias in
the estimate of the coefficient of the lagged dependent variable
which is not mitigated by increasing N, the number of individual
units.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Nickell Bias

The demeaning operation creates a regressor which cannot be

distributed independently of the error term. Nickell demonstrates
that the inconsistency of ρ̂ as N → ∞ is of order 1/T, which may be
quite sizable in a “small T” context. If ρ > 0, the bias is invariably
negative, so that the persistence of y will be underestimated.

For reasonably large values of T, the limit of (ρ̂ − ρ) as N → ∞ will be

approximately −(1 + ρ)/(T − 1): a sizable value, even if T = 10. With
ρ = 0.5, the bias will be -0.167, or about 1/3 of the true value. The
inclusion of additional regressors does not remove this bias. Indeed,
if the regressors are correlated with the lagged dependent variable
to some degree, their coefficients may be seriously biased as well.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Nickell Bias

Note also that this bias is not caused by an autocorrelated error

process . The bias arises even if the error process is i.i.d. If the
error process is autocorrelated, the problem is even more severe
given the difficulty of deriving a consistent estimate of the AR
parameters in that context.

The same problem affects the one-way random effects model. The
ui error component enters every value of yit by assumption, so that
the lagged dependent variable cannot be independent of the
composite error process.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Nickell Bias

One solution to this problem involves taking first differences of the

original model. Consider a model containing a lagged dependent
variable and a single regressor X:

yit = β1 + ρyi,t−1 + Xit β2 + ui + it (1)

The first difference transformation removes both the constant term

and the individual effect:

∆yit = ρ∆yi,t−1 + ∆Xit β2 + ∆it (2)

There is still correlation between the differenced lagged dependent

variable and the disturbance process (which is now a first-order
moving average process, or MA(1)): the former contains yi,t−1 and
the latter contains i,t−1 .

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Nickell Bias

But with the individual fixed effects swept out, a straightforward

instrumental variables estimator is available. We may construct
instruments for the lagged dependent variable from the second and
third lags of y, either in the form of differences or lagged levels. If  is
i.i.d., those lags of y will be highly correlated with the lagged
dependent variable (and its difference) but uncorrelated with the
composite error process.

Even if we had reason to believe that  might be following an AR(1)

process, we could still follow this strategy, “backing off” one period
and using the third and fourth lags of y (presuming that the
timeseries for each unit is long enough to do so).
This approach is the Anderson–Hsiao (AH) estimator implemented
by the Stata command xtivreg, fd.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

The DPD Approach

The DPD (Dynamic Panel Data) approach is usually considered the

work of Arellano and Bond (AB) (Rev. Ec. Stud., 1991), but they in
fact popularized the work of Holtz-Eakin, Newey and Rosen
(Econometrica, 1988). It is based on the notion that the instrumental
variables approach noted above does not exploit all of the
information available in the sample.

By doing so in a Generalized Method of Moments (GMM) context,

we may construct more efficient estimates of the dynamic panel
data model.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Arellano–Bond estimator

Arellano and Bond argue that the Anderson–Hsiao estimator, while

consistent, fails to take all of the potential orthogonality conditions
into account. A key aspect of the AB strategy, echoing that of AH, is
the assumption that the necessary instruments are ‘internal’: that is,
based on lagged values of the instrumented variable(s). The
estimators allow the inclusion of external instruments as well.
Consider the equations
yit = Xit β1 + Wit β2 + vit
vit = ui + it (3)
where Xit includes strictly exogenous regressors, Wit are
predetermined regressors (which may include lags of y) and
endogenous regressors, all of which may be correlated with ui , the
unobserved individual effect. First-differencing the equation
removes the ui and its associated omitted-variable bias.
DPD Estimator Dr. A Rashid, IIIE, Pakistan
Introduction An Empirical Exercise Illustration of System GMM

Arellano–Bond estimator

The AB approach, and its extension to the ‘System GMM’ context, is

an estimator designed for situations with:
I ‘small T, large N’ panels: few time periods and many individual
units
I a linear functional relationship
I one left-hand variable that is dynamic, depending on its own
past realisations
I right-hand variables that are not strictly exogenous: correlated
with past and possibly current realisations of the error
I fixed individual effects, implying unobserved heterogeneity
I heteroskedasticity and autocorrelation within individual units’
errors, but not across them

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Arellano–Bond estimator

The Arellano–Bond estimator sets up a generalized method of

moments (GMM) problem in which the model is specified as a
system of equations, one per time period, where the instruments
applicable to each equation differ (for instance, in later time periods,
additional lagged values of the instruments are available).

This estimator is available in Stata as xtabond. A more general

version, allowing for autocorrelated errors, is available as xtdpd. An
excellent alternative to Stata’s built-in commands is David
Roodman’s xtabond2, available from SSC (findit xtabond2).
It is very well documented in his paper, included in your materials.
The xtabond2 routine provides several additional features—such
as the orthogonal deviations transformation discussed below—not
available in official Stata’s commands.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Constructing the Instrument Matrix

In standard 2SLS, including the Anderson–Hsiao approach, the

twice-lagged level appears in the instrument matrix as
 
.
 yi,1 
Zi =  . 
 
 .. 
yi,T−2
where the first row corresponds to t = 2, given that the first
observation is lost in applying the FD transformation. The missing
value in the instrument for t = 2 causes that observation for each
panel unit to be removed from the estimation.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Constructing the Instrument Matrix

If we also included the thrice-lagged level yt−3 as a second

instrument in the Anderson–Hsiao approach, we would lose another
observation per panel:
 
. .
 yi,1
 .  
 yi,2 yi,1 
Zi =  
 .. .. 
 . . 
yi,T−2 yi,T−3
so that the first observation available for the regression is that dated
t = 3.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Constructing the Instrument Matrix

To avoid this loss of degrees of freedom, Holtz-Eakin et al. construct a set

of instruments from the second lag of y, one instrument pertaining to each
time period:  
0 0 ... 0

 yi,1 0 ... 0 

Zi = 
 0 yi,2 ... 0 

 .. .. .. .. 
 . . . . 
0 0 . . . yi,T−2
The inclusion of zeros in place of missing values prevents the loss of
additional degrees of freedom, in that all observations dated t = 2 and later
can now be included in the regression. Although the inclusion of zeros
might seem arbitrary, the columns of the resulting instrument matrix will be
orthogonal to the transformed errors. The resulting moment conditions
correspond to an expectation we believe should hold: E(yi,t−2 ∗it ) = 0,
where ∗ refers to the FD-transformed errors.
DPD Estimator Dr. A Rashid, IIIE, Pakistan
Introduction An Empirical Exercise Illustration of System GMM

Constructing the Instrument Matrix

It would also be valid to ‘collapse’ the columns of this Z matrix into a

single column, which embodies the same expectation, but conveys
less information as it will only produce a single moment condition. In
this context, the collapsed instrument set will be the same implied by
standard IV, with a zero replacing the missing value in the first
usable observation:
 
0
 yi,1 
Zi =  . 
 
 .. 
yi,T−2
This is specified in Roodman’s xtabond2 software by giving the
collapse option.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Constructing the Instrument Matrix

Given this solution to the tradeoff between lag length and sample
length, we can now adopt Holtz-Eakin et al.’s suggestion and include
all available lags of the untransformed variables as instruments. For
endogenous variables, lags 2 and higher are available. For
predetermined variables that are not strictly exogenous, lag 1 is also
valid, as its value is only correlated with errors dated t − 2 or earlier.
Using all available instruments gives rise to an instrument matrix
such as
 
0 0 0 0 0 0 ...
 yi,1 0
 0 0 0 0 ...  
 0 yi,2 yi,1 0
Zi =  0 0 . . . 

 0
 0 0 yi,3 yi,2 yi,1 . . .  
.. .. .. .. .. .. . .
. . . . . . .

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Constructing the Instrument Matrix

In this setup, we have different numbers of instruments available for

each time period: one for t = 2, two for t = 3, and so on. As we
move to the later time periods in each panel’s timeseries, additional
orthogonality conditions become available, and taking these
additional conditions into account improves the efficiency of the AB
estimator.
One disadvantage of this strategy should be apparent. The number
of instruments produced will be quadratic in T, the length of the
timeseries available. If T < 10, that may be a manageable number,
but for a longer timeseries, it may be necessary to restrict the
number of past lags used. Both the official Stata commands and
Roodman’s xtabond2 allow the specification of the particular lags
to be included in estimation, rather than relying on the default
strategy.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

The System GMM Estimator

A potential weakness in the Arellano–Bond DPD estimator was

revealed in later work by Arellano and Bover (1995) and Blundell
and Bond (1998). The lagged levels are often rather poor
instruments for first differenced variables, especially if the variables
are close to a random walk. Their modification of the estimator
includes lagged levels as well as lagged differences.

The original estimator is often entitled difference GMM, while the

expanded estimator is commonly termed System GMM. The cost of
the System GMM estimator involves a set of additional restrictions
on the initial conditions of the process generating y. This estimator
is available in Stata as xtdpdsys.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Diagnostic Tests

As the DPD estimators are instrumental variables methods, it is

particularly important to evaluate the Sargan–Hansen test results
when they are applied. Roodman’s xtabond2 provides C tests (as
discussed in re ivreg2) for groups of instruments. In his routine,
instruments can be either “GMM-style” or “IV-style”.

The former are constructed per the Arellano–Bond logic, making

use of multiple lags; the latter are included as is in the instrument
matrix. For the system GMM estimator (the default in xtabond2)
instruments may be specified as applying to the differenced
equations, the level equations or both.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Diagnostic Tests

Another important diagnostic in DPD estimation is the AR test for

autocorrelation of the residuals. By construction, the residuals of the
differenced equation should possess serial correlation, but if the
assumption of serial independence in the original errors is
warranted, the differenced residuals should not exhibit significant
AR(2) behavior. These statistics are produced in the xtabond and
xtabond2 output. If a significant AR(2) statistic is encountered, the
second lags of endogenous variables will not be appropriate
instruments for their current values.
A useful feature of xtabond2 is the ability to specify, for GMM-style
instruments, the limits on how many lags are to be included. If T is
fairly large (more than 7–8) an unrestricted set of lags will introduce
a huge number of instruments, with a possible loss of efficiency. By
using the lag limits options, you may specify, for instance, that only
lags 2–5 are to be used in constructing the GMM instruments.
DPD Estimator Dr. A Rashid, IIIE, Pakistan
Introduction An Empirical Exercise Illustration of System GMM

Data

To illustrate the performance of the several estimators, we make use

of the original AB dataset, available within Stata with webuse
abdata. This is an unbalanced panel of annual data from 140 UK
firms for 1976–1984. In their original paper, they modeled firms’
employment n using a partial adjustment model to reflect the costs
of hiring and firing, with two lags of employment.

Other variables included were the current and lagged wage level w,
the current, once- and twice-lagged capital stock (k) and the
current, once- and twice-lagged output in the firm’s sector (ys). All
variables are expressed as logarithms. A set of time dummies is
also included to capture business cycle effects.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Pooled OLS and FE

If we were to estimate this model ignoring its dynamic panel nature,

we could merely apply regress with panel-clustered standard
errors:
regress n nL1 nL2 w wL1 k kL1 kL2 ys ysL1 ysL2 yr*, cluster(id)

One obvious difficulty with this approach is the likely importance of

firm-level unobserved heterogeneity. We have accounted for
potential correlation between firms’ errors over time with the
cluster-robust VCE, but this does not address the potential impact of
unobserved heterogeneity on the conditional mean.
We can apply the within transformation to take account of this
aspect of the data:

xtreg n nL1 nL2 w wL1 k kL1 kL2 ys ysL1 ysL2 yr*, fe cluster(id)

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Nickell Bias

The fixed effects estimates will suffer from Nickell bias, which may
be severe given the short timeseries available.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

Nickell Bias

In the original OLS regression, the lagged dependent variable was

positively correlated with the error, biasing its coefficient upward. In
the fixed effects regression, its coefficient is biased downward due to
the negative sign on νt−1 in the transformed error. The OLS estimate
of the first lag of n is 1.045; the fixed effects estimate is 0.733.

Given the opposite directions of bias present in these estimates,

consistent estimates should lie between these values, which may be
a useful check. As the coefficient on the second lag of n cannot be
distinguished from zero, the first lag coefficient should be below
unity for dynamic stability.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

The Anderson–Hsiao estimator

To deal with these two aspects of the estimation problem, we might

use the Anderson–Hsiao estimator to the first-differenced equation,
instrumenting the lagged dependent variable with the twice-lagged
level:
ivregress 2sls D.n (D.nL1 = nL2) D.(nL2 w wL1 k kL1 kL2 ///
ys ysL1 ysL2 yr1979 yr1980 yr1981 yr1982 yr1983 )

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

The Anderson–Hsiao estimator

Although these results should be consistent, they are quite

disappointing. The coefficient on lagged n is outside the bounds of
its OLS and FE counterparts, and much larger than unity, a value
consistent with dynamic stability. It is also very imprecisely
estimated.
DPD Estimator Dr. A Rashid, IIIE, Pakistan
Introduction An Empirical Exercise Illustration of System GMM

The difference GMM approach

The difference GMM approach deals with this inherent endogeneity

by transforming the data to remove the fixed effects. The standard
approach applies the first difference (FD) transformation, which as
discussed earlier removes the fixed effect at the cost of introducing
a correlation between ∆yi,t−1 and ∆νit , both of which have a term
dated (t − 1). This is preferable to the application of the within
transformation, as that transformation makes every observation in
the transformed data endogenous to every other for a given
individual.
The one disadvantage of the first difference transformation is that it
magnifies gaps in unbalanced panels. If some value of yit is missing,
then both ∆yit and ∆yi,t−1 will be missing in the transformed data.
This motivates an alternative transformation: the forward orthogonal
deviations (FOD) transformation, proposed by Arellano and Bover
(J. Econometrics, 1995).
DPD Estimator Dr. A Rashid, IIIE, Pakistan
Introduction An Empirical Exercise Illustration of System GMM

The forward orthogonal deviations (FOD)

In contrast to the within transformation, which subtracts the average

of all observations’ values from the current value, and the FD
transformation, that subtracts the previous value from the current
value, the FOD transformation subtracts the average of all available
future observations from the current value. While the FD
transformation drops the first observation on each individual in the
panel, the FOD transformation drops the last observation for each
individual. It is computable for all periods except the last period,
even in the presence of gaps in the panel.
The FOD transformation is not available in any of official Stata’s
DPD commands, but it is available in David Roodman’s xtabond2
implementation of the DPD estimator, available from SSC.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

xtabond2

To illustrate the use of the AB estimator, we may reestimate the

model with xtabond2, assuming that the only endogeneity present
is that involving the lagged dependent variable.

xtabond2 n L(1/2).n L(0/1).w L(0/2).(k ys) yr*, gmm(L.n) ///

iv(L(0/1).w L(0/2).(k ys) yr*) nolevel robust small

Note that in xtabond2 syntax, every right-hand variable generally appears

twice in the command, as instruments must be explicitly specified when
they are instrumenting themselves. In this example, all explanatory
variables except the lagged dependent variable are taken as “IV-style”
instruments, entering the Z matrix as a single column. The lagged
dependent variable is specified as a “GMM-style” instrument, where all
available lags will be used as separate instruments. The noleveleq
option is needed to specify the AB estimator.
DPD Estimator Dr. A Rashid, IIIE, Pakistan
Introduction An Empirical Exercise Illustration of System GMM

xtabond2

In these results, 41 instruments have been created, with 17 corresponding

to the “IV-style” regressors and the rest computed from lagged values of n.
Note that the coefficient on the lagged dependent variable now lies within
the range for dynamic stability. In contrast to that produced by the
Anderson–Hsiao estimator, the coefficient is quite precisely estimated.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

The Hansen J test

There are 25 overidentifying restrictions in this instance, as shown in

the first column below. The hansen df represents the degrees of
freedom for the Hansen J test of overidentifying restrictions. The
p-value of that test is shown as hansenp.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

The Sensitivity of the Results

In this table, we can examine the sensitivity of the results to the

choice of “GMM-style” lag specification. In the first column, all
available lags of the level of n are used. In the second column, the
lag(2 5) option is used to restrict the maximum lag to 5 periods,
while in the third column, the maximum lag is set to 4 periods.
Fewer instruments are used in those instances, as shown by the
smaller values of sar df.

The p-value of Hansen’s J is also considerably larger for the

restricted-lag cases. On the other hand, the estimate of the lagged
dependent variable’s coefficient appears to be quite sensitive to the
choice of lag length.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

The Sensitivity of the Results

We illustrate estimating this equation with both the FD transformation and

the forward orthogonal deviations (FOD) transformation:

The results appear reasonably robust to the choice of transformation, with

slightly more precise estimates for most coefficients when the FOD
transformation is employed.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

The Sensitivity of the Results

We might reasonably consider, as did Blundell and Bond (J.

Econometrics, 1998), that wages and the capital stock should not be
taken as strictly exogenous in this context, as we have in the above
models.

Reestimate the equation producing “GMM-style” instruments for all

three variables, with both one-step and two-step VCE:

xtabond2 n L(1/2).n L(0/1).w L(0/2).(k ys) yr*, gmm(L.(n w k)) ///

iv(L(0/2).ys yr*) nolevel robust small

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

The Sensitivity of the Results

The results from both one-step and two-step estimation appear

reasonable. Interestingly, only the coefficient on ys appears to be more
precisely estimated by the two-step VCE. With no restrictions on the
instrument set, 74 overidentifying restrictions are defined, with 90
instruments in total.
DPD Estimator Dr. A Rashid, IIIE, Pakistan
Introduction An Empirical Exercise Illustration of System GMM

System GMM: The First Empirical Exercise

To illustrate system GMM, we follow Blundell and Bond, who used

the same abdata dataset on a somewhat simpler model, dropping
the second lags and removing sectoral demand. We consider wages
and capital as potentially endogenous, with GMM-style instruments.
Estimate the one-step BB model.

xtabond2 n L.n L(0/1).(w k) yr*, gmm(L.(n w k)) iv(yr*,

equation(level)) robust small

We indicate here with the equation(level) suboption that the

year dummies are only to be considered instruments in the level
equation. As the default for xtabond2 is the BB estimator, we omit
the noleveleq option that has called for the AB estimator in earlier
examples.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: The First Empirical Exercise

We find that the α coefficient is much higher than in the AB

estimates, although it may be distinguished from unity. 113
instruments are created, with 100 degrees of freedom in the test of
overidentifying restrictions.
DPD Estimator Dr. A Rashid, IIIE, Pakistan
Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

We also illustrate DPD estimation using the Penn World Table

cross-country panel. We specify a model for kc (the consumption
share of real GDP per capita) depending on its own lag, cgnp, and
a set of time fixed effects, which we compute with the xi command,
as xtabond2 does not support factor variables.

We first estimate the two-step ‘difference GMM’ form of the model

with (cluster-)robust VCE, using data for 1991–2007. We could use
testparm I* after estimation to evaluate the joint significance of
time effects (listing of which has been suppressed).

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

(continued)

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

Given the relatively large number of time periods available, I have

specified that the GMM instruments only be constructed for lags 2–9
to keep the number of instruments manageable. I am treating
openc as a GMM-style instrument. The autoregressive coefficient is
0.648, and the cgnp coefficient is positive and significant. Although
not shown, the test for joint significance of the time effects has
p-value 0.0270.

We could also fit this model with the ‘system GMM’ estimator, which
will be able to utilize one more observation per country in the level
equation, and estimate a constant term in the relationship. I am
treating lagged openc as a IV-style instrument in this specification.

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

(continued)

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

Note that the autoregressive coefficient is much larger: 0.945 in this

context. The cgnp coefficient is again positive and significant, but
has a much smaller magnitude when the system GMM estimator is
used.

We can also estimate the model using the forward orthogonal

deviations (FOD) transformation of Arellano and Bover, as described
in Roodman’s paper. The first-difference transformation applied in
DPD estimators has the unfortunate feature of magnifying any gaps
in the data, as one period of missing data is replaced with two
missing differences. FOD transforms each observation by
subtracting the average of all future observations, which will be
defined (regardless of gaps) for all but the last observation in each
panel. To illustrate:

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

(continued)

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

Using the FOD transformation, the autoregressive coefficient is a bit

larger, and the cgnp coefficient a bit smaller, although its
significance is retained.

After any DPD estimation command, we may save predicted values

or residuals and graph them against the actual values:

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

(continued)

DPD Estimator Dr. A Rashid, IIIE, Pakistan

Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

ESP GRC
70
65
60
55

ITA PRT
70
65
60
55

1990 1995 2000 2005 1990 1995 2000 2005

year

Consumption / Real GDP per capita Fitted Values

Graphs by ISO country code
DPD Estimator Dr. A Rashid, IIIE, Pakistan
Introduction An Empirical Exercise Illustration of System GMM

System GMM: A Second Empirical Exercise

Although the DPD estimators are linear estimators, they are highly
sensitive to the particular specification of the model and its
instruments: more so in my experience than any other
regression-based estimation approach.

There is no substitute for experimentation with the various

parameters of the specification to ensure that your results are
reasonably robust to variations in the instrument set and lags used.
A very useful reference for DPD modeling is David Roodman’s
paper “How to do xtabond2” paper, freely downloadable from the
Stata Journal via IDEAS or EconPapers.

DPD Estimator View publication stats Dr. A Rashid, IIIE, Pakistan